Martin Kronicle

The Business Insider delineated 14 possible crises that could shake up the markets if they occurred. All 14 are “headline grabbers” and the talk of Twitter, but there is one that went unnoticed and I haven’t seen it mentioned on the WWW: correlation risk between equities and long-only commodities.

All you need is one unsuspected event in the US – forget the 14 in the article – and you’ll see your portfolio lose more than you might realize.

Stocks are leading the Bull markets, while commodities are following, as stocks are forecasting positive GDP growth. Moreover, there is more available capital to buy stocks than to buy
commodities, so this has also helped stocks outperform commodities recently. Thereby, commodities have been in a long trading range (in aggregate) from June 2009 to date, only creeping up.

However, amazingly the long-only commodity universe has had a tremendous positive correlation with stocks since January 2008; the S&P 500 has a 97.92% and 98.32% correlation to the DJUBS and the S&P GSCI (Long Only) Commodity Indexes, respectively.

Interestingly, the appreciation of these commodity indexes as represented by their ETNs (DJP and GSP was +25.5% and +37.1%, respectively, from March 2009 through the end of March
2010, while the S&P 500 has rallied 72.86% during such time period.

Due to the highest correlation I have ever seen between two different asset classes (even Long- Term U.S. Government Bonds have only a 93.9% historical correlation to Intermediate-Term Government Notes), if growth is lower than expected (3%-4%) both commodities and stocks should decline.

Source: EAM Partners, LP

That means you’re not going to see any diversification benefits in the short-term if the S&P goes south and you are a long-only investor. Worse, because the correlation to equities is so high, you’re going to lose on your long-only commodity investment(s) at the same time, making the % hit to your portfolio much greater than you may be expecting.

“When someone shares something of value with you and you benefit from it, you have a moral obligation to share it with others.” – Chinese Proverb

Paul Tudor Jones said “I always believe that prices move first and the fundamentals come second.” – from Market Wizards by Jack Schwager

Remember that quote…

According a NYT article U.S. Farmers Plan a Record Soybean Planting, “American farmers expect to plant 88.8 million acres of corn — the second-largest acreage since 1946 — and a record 78.1 million acres of soybeans in response to high prices for the crops, the government said on Wednesday.”

High prices cure high prices…

The article also stated that “the Department of Agriculture said there were 7.69 billion bushels of corn in warehouses and grain bins on March 1, the largest amount since 1987 and more than was expected by traders.”

Here is the chart of the December Corn contract. The two red arrows indicate the dates March 1 and March 31. (Click to enlarge)

Here is the chart of November Soybeans. The two red arrows indicate the dates March 1 and March 31. (Click to enlarge)

A couple of things could have happened here:

1) Speculators drove down the prices by selling corn and soybeans short. Speculators hereby aid consumers.

2) Producers, noting higher prices in Q4, decided to concurrently sell futures and plant to capture higher potential profits.

Regardless what you may think, you MUST follow the price first.

Why? Well remember to look at the two red arrows: The first (on the left) is the March 1 date of the crop report from the DOA stating the potential for bumper crops in corn and soybeans. The red line on the right of both charts signifies the date of the NYT article – a month later – March 31.

I would state that both the March 1 DOA Report and the March 31 NYT article are lagging indicators, from a trader’s perspective, so to speak. They are not technical indicators, of course.

Most importantly, during Q4 2009, farmers (hedgers) had a sense of prices, supply, and demand and acted accordingly. They have perfect knowledge of what supply they can supply above what the rest of the market can only estimate.

Prices move first, and fundamentals follow. Had you been long waiting for the news, you’d be sitting in losses. Had you been long but placed protective sell stop orders in, you’d now come to understand why you got stopped out for small losses – and you’d have more cash in your account.

Protect your capital at all times.